How Yelp's Business Works

Local reviews site Yelp is set to price their upcoming IPO tonight. According to a report in the Wall Street Journal, it will sell 7.15 million shares at a price of $12 to $14. That would value the company at $838.6 million at the high end of that range.

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Yelp has grown by getting users to write reviews of businesses, engaging them through social networking features, and piggybacking on search engine traffic.

Yelp users can not only search for and review businesses, but they can create a profile, ‘friend’ other users, chat in online forums, and even go to offline meet-ups.

Yelp uses Facebook to find and connect with your friends as soon as you sign up (see screenshot below).

Yelp has ~ 66 million monthly unique visitors, is used on more than 5.7 million mobile devices, and has collected a total of 25 million reviews since its inception in 2004 (see breakdown of reviews by business segment in the chart above).

But how exactly does it make money?

Yelp generates almost all of its revenue from advertising—91.4 percent for 2011. It's primarily two kinds of advertising:

Local advertising from businesses that want to be featured on Yelp, which is 76.8 percent of total ad revenue.

How do the local ads work? Restaurants, clothing stores, or beauty salons pay Yelp for the right to prominently appear first on any given search, with the review of their choice as the teaser (see screenshot). So if a Yelp user searches for “Thai food” in San Francisco, they will first be directed to the advertising restaurant before being shown organic results.

The remainder of the company’s revenue is largely from Yelp Deals, a Groupon-like daily deals business which Yelp is scaling down. (See revenue breakdown below.)

Although Yelp is not currently profitable, the company believes that its user-generated "network effect" will drive revenue growth and sustain future profitability.

Our platform helps people find great local businesses to meet their everyday needs. As more people use our platform, more of them write reviews. Each review that a user contributes helps expand the breadth and depth of the content on our platform, in turn drawing in more consumers. This increase in consumer traffic improves our value proposition to local businesses as they seek low-cost, easy-to-use and effective advertising solutions to target a large number of intent-driven consumers.

In other words, Yelp thinks its depth and breadth of customer reviews create a network effect.

Yelp enters a new market and begins creating profiles for local businesses (what they call ‘claimed business locations’). Users then begin to write reviews, which in turn spurs user adoption and more reviews, creating a snowball effect until Yelp becomes the definitive guide to local businesses in their market. At this point, Yelp can pitch itself as a cost-effective advertising platform for local businesses.

Although it may sound a bit far-flung, this can and has worked in certain markets. In San Francisco, its first and most developed market, Yelp is widely accepted as the most effective way to search and find local businesses—even my Luddite parents have become avid Yelp users. Once it has a critical mass of reviews, Yelp can deliver much more relevant results on hyperlocal searches than traditional search engines (see screenshot at right of hyper local search; users can drag the map to change results).

At its best, Yelp is a thorough and useful local guide, like a crowd-sourced Zagat. Mean-spirited or weird online reviewers stop being a problem if businesses have over 100 reviewers (as is commonly the case for businesses in Yelp’s most developed markets).

However, it remains to be seen if Yelp will be able to duplicate this success in other markets. They have seen impressive year-over-year growth in several key metrics: reviews (64 percent), unique monthly visitors (67 percent), claimed local businesses (97 percent), and active local advertisers (118 percent). Nonetheless, despite these gains, Google still accounts for 75 percent of Yelp’s traffic. In other words, Yelp is excellent at search engine optimization, but has not yet succeeded in becoming a stand-alone web destination in most of its markets.

So while Yelp's user growth is impressive, we don't think they have a real network effect and they have a long road ahead to become as central in most markets as it has been in San Francisco.

The Sales Question

Yelp also has the classic problem that local advertising businesses face scaling their business: it is a heavily sales-driven process.

Yelp needs hundreds of salespeople to sell its local advertising products to local businesses, many of whom are probably not the most tech-savvy. In 2010, 350 of Yelp's 500 employees were sales people. Applying that ratio to its current headcount of 918, Yelp might currently employ 643 salesmen and women. At 24,000 active local business accounts, this means every salesperson handles over 37 active accounts a piece.

This is a big reason why Yelp is not profitable, and should not expect to be for a while: Yelp needs to invest in an enormous sales force to generate revenue from local advertising.

What's more, though Yelp has changed its advertising products and methods, it has had an adversarial relationship with merchants in the past, and still has a bad reputation in some markets.

THE BOTTOM LINE

While we think that Yelp’s local review platform is great product, we have reservations about their business model because:

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